Defined contribution plan investors are lousy investors, and what's more, they know it, according to a recent study of participants in 401(k) and 403(b) plans.
The study covered participants of SwedishAmerican Health System's $86 million defined contribution plans and the University of California at Los Angeles' deferred compensation plan.
Most participants in those plans - even those who previously rejected the opportunity to have experts devise their portfolios - found the median investment portfolio more attractive than the one they chose themselves.
The main problem, the study found, is that defined contribution plan participants do not know what their risk preferences are, said Shlomo Benartzi, professor at The Anderson School, UCLA, who ran the study with Richard H. Thaler, professor of economics at the University of Chicago, Graduate School of Business.
Automatic portfolio preferred
At SwedishAmerican, Rockford, Ill., the majority of participants who opted out of the plan's automatic professional management feature preferred the portfolio they would have gotten to the one they crafted. (Indeed, Tom Koelbl, vice president of human resources at SwedishAmerican, said participation in the automatic professionally managed feature has grown to 86% from around 80% during the roughly 18 months the feature has been offered.)
UCLA's 22,000 participants did not have a similar option in their 403(b) plan. However when faced with the predicted outcomes of investment portfolios they had selected and a median portfolio, most of the plan participants studied preferred the median portfolio selected by their peers.
"Finding the right level of risk that fits us is a very tough job," Mr. Benartzi said. "People are not sure what their preferences are." When you ask people whether they prefer milk chocolate or dark chocolate, they can choose easily because they most likely have tasted both many times and know what they like best, Mr. Benartzi explained. This is not the case with investment risk tolerance, he said.
"Not many participants have experience with the exact tradeoff between risk and return," he said. "Those preferences might not be well defined."
The study concluded that whatever benefits there are in allowing plan participants to chose their own investment portfolios within defined contribution plans, they are likely to reach the maximum benefit with a small number of investment options. Moreover, plan sponsors should use "extreme care" in selecting investment options, Mr. Benartzi said.
"When there is an array of balanced funds with a range of risk levels, some investors will be attracted to the middle one, simply because of its relative position," Messrs. Benartzi and Thaler noted. "This result implies that plan sponsors, when choosing the array of funds, may be implicitly (and unintentionally) `suggesting' particular funds or asset allocations."
SwedishAmerican's 401(k) and 403(b) plans have identical investment options. Under the professional money management program, portfolios are selected by Chicago-based ProManage Inc., formerly Strategic Financial Concepts Inc., which is merging with I C M Asset Management, Spokane, Wash. ProManage's allocations are based on demographic factors such as age, but not on individual risk preferences.
ProManage typically uses seven of the plans' 11 investment options, Mr. Koelbl said: Robertson Stephens Emerging Markets and Emerging Growth funds; T. Rowe Price's Dividend Growth fund; Equity Index 500 and International Stock funds; Deutsche Preservation Plus fund; and Artisan Small-Cap Value fund. Plan participants who opt out of ProManage also can invest in Dresdner RCM Large-Cap Growth fund, T. Rowe Price's Spectrum Income and Total Equity Market index funds, and a mutual fund window. T. Rowe Price is the plan's semi-bundled provider, Mr. Koelbl added.
SwedishAmerican chose ProManage as the plans' default because "people wanted choice, but they did not want to take the time and energy to make the right choices," Mr. Koelbl said.
Messrs. Benartzi and Thaler studied those participants who had opted out of the ProManage program at SwedishAmerican, choosing to manage their own portfolios. Those participants were given three unmarked portfolios: a ProManage portfolio; the average portfolio of SwedishAmerican participants; and the participant's own asset mix.
After seeing income projections based on each of the three portfolios, participants preferred the average portfolio more than the other two. Some 44% of the participants preferred the average portfolio, while 22% were indifferent and 34% preferred their own portfolios. Sixty-one percent of participants preferred the ProManage portfolios, 19% were indifferent and only 20% preferred their own portfolios. In the study, participants were asked not to choose among the three, but rather to pick separately between their portfolio and the average; their portfolio vs. the ProManage recommendation; and then between the average portfolio and the ProManage allocation. (Financial Engines Inc., the Palo Alto, Calif.-based investment advisory firm, did the income projections used in the study.)
"In summary, we find that investor autonomy is not worth much," stated Messrs. Benartzi and Thaler. "Ruling out differences in opinion, we believe the people fail to diversify, or, alternatively, they pick the wrong point along the efficient frontier."